The Yellow Brick Road to [Q]Oz Becomes Clearer
A significant new tax incentive was added by the Tax Cuts and Jobs Act of 2017, which allows taxpayers to defer paying tax on capital gains from the sale of any asset and completely eliminate from federal income tax a portion of these deferred capital gains and all of the appreciation in certain investments. However, to maximize these tax benefits, investors must act before the end of 2019. This new program (QOZ program) provides these tax incentives for taxpayers investing in certain specified communities designated as qualified opportunity zones (QOZ).[1]
Following enactment of the QOZ program, the Department of Treasury released initial proposed regulations (initial regulations) on October 29, 2018,[2] and subsequently released additional proposed regulations (new regulations) on April 17, 2019.[3] While a number of questions regarding the QOZ program remain outstanding, the release of the initial regulations and new regulations have given investors and fund sponsors confidence to move forward with QOZ investments, especially investments in real estate. This article does not discuss all of the intricacies of the QOZ program, but instead, focuses on real estate investments under the QOZ program and provides a summary of the current state of the QOZ program following the release of the new regulations.
This article uses the following fact pattern to provide examples of the various QOZ program rules: investor previously purchased publicly traded stock (stock) for $1 million. On March 11, 2019, investor sells the stock for $10 million, triggering $9 million of capital gain. On September 5, 2019, the investor contributes $9 million to a qualified opportunity fund (QOF), which is taxable as a partnership for federal income tax purposes, and investor receives an 80% equity interest in the QOF.
Benefits to Investors
The QOZ program provides four principle tax benefits to investors (QOF investor). First, the QOF investor may defer capital gain from the sale of any asset sold to an unrelated party by timely investing in a QOF.[4] Importantly, and unlike a §1031[5] real estate exchange, a QOF investor is only required to reinvest the amount of the capital gain in the QOF. The QOF investor may use the remaining amount received from the sale of the asset — typically an amount equal to the taxpayer’s basis in the asset — for any other purpose and still obtain deferral of all the capital gain.
The second and third benefit eliminate up to 15% of the QOF investor’s deferred gain if the QOF investor holds its equity interest in the QOF (QOF interest) for the requisite time periods, which are accomplished through a basis step-up mechanism in the QOF interest. For example, the QOF investor eliminates 10% of the deferred capital gain if the QOF interest is held for at least five years and eliminates an additional 5% of the deferred gain if the QOF interest is held for at least seven years.[6] Finally, the QOF investor eliminates all federal income tax on the appreciation of the QOF interest if the QOF interest is held for at least 10 years.[7]
Limitations and Drawbacks to Investing
Although the QOZ program provides significant tax benefits, the program also provides a number of limitations and potential drawbacks to investing in a QOF. First, a QOF interest must be an equity interest (e.g., not debt) of the QOF and must be received in exchange for cash or other property.[8] The new regulations confirm that a QOF interest received in exchange for services does not qualify for the QOZ program benefits, which denies the QOZ program benefits for promotes and carried interest.[9]
Second, the QOZ program benefits are only available to the extent the QOF investor has capital gains from the sale of an asset to an unrelated party.[10] In other words, the program benefits are not available to the extent a sale or exchange triggers ordinary income (e.g., depreciation recapture), and any gain from the sale of an asset to a related party is similarly not eligible for the QOZ program benefits. For these purposes, certain family relationships and common ownership of more than 20% are deemed related.[11]
Third, the QOF investor must make its QOF investment within 180 days from the date on which the gain would be recognized for federal income tax purposes.[12] Owners in certain flow-through entities for federal income tax purposes (e.g., partnerships and S corporations) (flow-through entity), however, have additional flexibility. Specifically, if a flow-through entity does not elect to defer its capital gains, owners of the flow-through entity may choose to begin the 180-day period on either the last day of the flow-through entity’s taxable year or when the flow-through entity itself would begin the 180-day period (i.e., the date the gain would be recognized for federal income tax purposes).[13]
Finally, and most importantly, the amount of deferred capital gain (less the potential 15% gain elimination discussed above) is recognized on the earlier of 1) December 31, 2026; and 2) the date on which the QOF interest is sold or exchanged.[14] Consequently, if the QOF investor has not otherwise recognized the deferred gain, the QOF investor will recognize all of the deferred gain (less the potential 15% gain elimination discussed above) in the year ending December 31, 2026, even if the QOF investor continues holding the QOF interest after such date. In this case, the QOF investor will have “phantom income” and may need to obtain funds from other sources to pay the tax due. However, subject to certain limitations, the new regulations permit the QOF to make distributions to QOF investors from a subsequent refinancing, which could be timed to coincide with this phantom income.[15]
The new regulations also accelerate recognition of the deferred gain upon certain “inclusion events,” including events that are in the QOF investor’s control (e.g., a gift of the QOF interest) and events that are not in the QOF investor’s control (e.g., certain distributions from the QOF).[16] The new regulations also confirm that a transfer of a QOF interest upon the investor’s death is not an inclusion event, but §1400Z-2(e)(3) provides that the deferred gain is income in respect of a decedent under §691, which causes the estate, beneficiary, or other holder of the QOF interest to recognize the deferred gain on December 31, 2026, (less the potential 15% gain elimination discussed above) if not previously recognized.
• Example 1 (Qualifying Investment in QOF) — Facts are the same as the fact pattern on page 1. Investor holds QOF interest until March 31, 2029, at which point investor sells QOF interest for $20 million.
Analysis: Since the investor timely invested in a QOF, the entire $9 million gain realized upon the sale of the stock is deferred, and the investor may use the remaining portion of the proceeds from the sale of stock (i.e., $1 million) for any purpose. At this point, her QOF interest has a basis of zero, since the entire $9 million investment represents deferred gain. Five years after acquiring his or her QOF interest (i.e., September 5, 2024), the investor automatically eliminates 10% of the deferred gain when the basis increases to $900,000 (i.e., 10% of $9 million). Two years later, and seven years after acquiring QOF interest (i.e., September 5, 2026), the investor automatically eliminates an additional 5% of the deferred gain when the basis increases by an additional $450,000 (i.e., 5% of $9 million). At this point, the investor’s aggregate basis in his or her QOF interest is $1,350,000 (i.e., $900,000 plus $450,000), and she has effectively eliminated $1,350,000 of capital gain from federal income tax.
Since the investor did not previously dispose of his or her QOF interest, he or she must recognize the deferred gain (less basis step-up) on December 31, 2026, which is $7.65 million (i.e., $9 million minus $1.35 million). When the investor sells the QOF interest after 10 years (i.e., on September 31, 2029), he or she owes no federal income tax on the $20 million received, including the $11 million appreciation of his or her QOF interest.
•Example 2 (Investments after December 31, 2019) — Same facts as example 1, except the stock was sold on October 31, 2019, and the QOF interest was acquired on January 15, 2020.
Analysis: The investor timely invested in the QOF, and therefore, the $9 million of gain realized upon the sale of the stock is deferred. Five years after acquiring the QOF interest (i.e., January 15, 2025), the investor automatically eliminates 10% of the deferred gain by increasing the QOF interest basis by $900,000. However, the investor will not obtain the additional 5% basis step-up because the seven-year anniversary of the date he or she acquired the QOF interest is January 15, 2027 (i.e., after December 31, 2026). Therefore, investor recognizes $8.1 million of deferred gain on December 31, 2026, as opposed to only $7.65 million from example 1. As shown in this example 2, in order to obtain the maximum QOZ program tax benefits, investors must make their investment in the QOF by December 31, 2019.
• Example 3 (Gifts of QOF Interest) — Assume the same facts as example 1, except the investor makes a gift of the QOF interest to a son (A) on January 25, 2025.
Analysis: As previously discussed, the new regulations confirm that a gift of a QOF interest is an inclusion event, which will cause the investor’s deferred gain to be recognized in the year of the gift. As a result, the investor will recognize $8.1 million in 2025, which is the investor’s initial deferred gain less a five-year basis step-up. Importantly, the investor will have to fund the tax associated with this gain recognition event from other sources, since the gift of the QOF interest did not provide the investor with any cash.
•Example 4 (Transfers Upon Death) — Same facts as example 1, except the investor dies on September 5, 2026, and the investor’s son, A, receives the QOF interest on December 15, 2026.
Analysis: A will be required to include in his income the $7.65 million gain under §691 as income in respect of a decedent in the year ending December 31, 2026. This tax liability could place A in an extremely difficult financial position, especially if A’s principal asset is an illiquid QOF interest.
•Example 5 (Related-Party Sales) — Assume the same facts as example 1, except that instead of selling the stock, the investor sells a piece of vacant land to A, her son, triggering the investor’s capital gain.
Analysis: Since the sale of the vacant land was to a related party, investor’s son, the gain from such sale is not eligible for the QOZ program.
How to Invest in a QOZ
In order to obtain the QOZ program benefits, a QOF investor may not acquire QOZ real estate directly, but instead, must invest in QOZ real estate through a QOF (i.e., a qualified opportunity fund). A QOF is any investment vehicle that meets the following three requirements (collectively, the QOF requirements). First, the QOF must be formed for the purpose of investing in “qualified opportunity zone property” (the purpose test). Second, the QOF must be organized as a partnership or corporation for federal income-tax purposes and formed in one of the 50 United States, the District of Columbia, or, in certain situations, a U.S. possession (organizational test). Finally, the QOF must hold at least 90% of its assets (90% asset test) in qualified opportunity zone property (QOZP), which is either 1) qualified opportunity zone business property (QOZBP); or 2) equity interests in subsidiaries that are taxable as partnerships or corporations (a QOF subsidiary) that own QOZBP.[17] If the QOF meets all of the requirements, then the QOF simply self-certifies as to its QOF status by filing Form 8996 with the IRS.
1) The Organizational Test and Purpose Test: The first two QOF requirements are relatively straightforward and easy to satisfy. For instance, the organizational test may be satisfied by forming an entity in Florida (e.g., a limited liability company (LLC)), so long as that entity is taxable as a partnership or corporation for federal income-tax purposes. Notably, an LLC that is a disregarded entity for federal income tax purposes is not eligible to be a QOF.
The purpose test may also be satisfied by simply including a statement in the QOF’s organizing documents that the QOF’s purpose is investing in QOZP and a description of the QOZP.[18] For instance, a QOF that is formed as a Florida LLC to invest in real estate could satisfy the purpose test by including a statement in its articles of organization and operating agreement that such LLC is formed for the purpose of qualifying as a QOF and describing the real estate QOZP.
2) The 90% Asset Test: The QOF must also meet the 90% asset test, which requires that 90% of the QOF’s assets be either QOZBP or equity interests in QOF subsidiaries. The QOF must satisfy the 90% asset test on the last day of its first six-month taxable period and on the last day of each taxable year.[19] Importantly, cash is not QOZBP, and as a result, if more than 10% of the QOF’s assets are cash on the relevant testing dates, then the QOF would fail the 90% asset test.
As discussed in more detail below, simply buying and holding real estate is not sufficient for QOZ investments. Instead, the QOZ real estate generally must be substantially improved (as defined below), which can be accomplished by developing or redeveloping the real estate.
QOF investors must make their investment in the QOF within 180 days of the sale generating the capital gain, which will cause a large infusion of cash in the QOF’s first few months. The QOF, however, must have less than 10% of its assets in cash at the end of its first six-month period to satisfy the 90% asset test.[20] Large real estate projects may take years to complete (including obtaining permits, construction, etc.), and as a result, a QOF may have difficulty deploying 90% of the cash received from QOF investors during its first six-month period.
• Example 6 (Cash and QOZBP) — The facts are the same as example 1, except that following investor’s $9 million contribution, the QOF purchases, from an unrelated third-party, land (Blackacre) located within a QOZ with a commercial building located on Blackacre (building) for $5 million. The QOF intends to use the remaining $4 million in cash received from the investor to redevelop the building, but prior to redevelopment, the QOF must obtain the necessary permits from local governments, which will not be obtained for nine months to one year.
Analysis: The QOF must satisfy the 90% asset test by the end of its first six-month taxable period (i.e., December 31, 2019), but due to the permitting process, the QOF will be unable to invest the additional $4 million in cash received from the investor until these permits are obtained, which will be after the December 31, 2019, testing date. As discussed above, cash is not QOZBP. As a result, the QOF will fail the 90% asset test since it has $4 million in cash and $5 million in QOZBP (i.e., the QOF has more than 10% of its assets in cash). As discussed below, however, excess cash may be held by a QOF subsidiary, subject to certain limitations.
3) Investments in QOF Subsidiaries: As previously mentioned, the 90% asset test requires that 90% of the QOF’s assets be QOZP, which includes equity interests (subsidiary interest) in QOZ subsidiaries. To qualify as QOZP, the subsidiary interest must meet three rules (QOF subsidiary rules). First, the QOF must acquire the subsidiary interest solely for cash after December 31, 2017. Second, the QOF subsidiary must be an entity that is taxable as either a partnership or corporation for federal income tax purposes (e.g., the QOF subsidiary may not be a disregarded entity). Finally, when the QOF acquires the subsidiary interest, and during substantially all of its holding period of the subsidiary interest, the QOF subsidiary must be a qualified opportunity zone business (QOZB).[21]
• Example 7 (Subsidiary Interest Acquired for Cash) — Facts are the same as example 1, except the QOF uses the $9 million received from investor to acquire a subsidiary interest, constituting a 95% equity interest, from an LLC taxable as a partnership for federal income tax purposes.
Analysis: The first two QOF subsidiary rules are satisfied since the QOF acquired its subsidiary interest for cash after December 31, 2017, and the LLC is taxable as a partnership for federal income-tax purposes. Assuming the QOF subsidiary meets the third QOF subsidiary rule (i.e., the QOF subsidiary qualifies as a QOZB), then the QOF satisfies the 90% asset test since 100% of its assets are QOZP (i.e., the QOF’s only asset, the subsidiary interest, is QOZP).
1) QOZB Requirement: The third QOF subsidiary rule requires that a QOF subsidiary be a QOZB (i.e., a qualified opportunity zone business), and in order to be a QOZB, the QOF subsidiary must meet the following requirements: 1) 70% of its tangible property is QOZBP (70% property test); 2) at least 50% of its gross income is from the active conduct of a trade or business in the QOZ; 3) a substantial portion of its intangible property is used in the active conduct of such trade or business; 4) less than 5% of its property is in nonqualified financial property (5% cash test); and 5) it does not operate certain specified “sin businesses,” including golf courses, country clubs, massage parlors, hot tub facilities, or any store where the principal business is the sale of alcoholic beverages for consumption off premises.[22]
2) The 70% Property Test and QOZBP: The 70% property test requires that 70% of the QOF subsidiary’s tangible property be QOZBP,[23] and provides a QOF subsidiary with more flexibility than the 90% asset test required for a QOF; the QOF subsidiary must have only 70% of its tangible property be QOZBP, as opposed to 90% of assets for a QOF. While cash is an asset, and a bad asset, in calculating the 90% asset test, cash in bank accounts generally is not “tangible property,” and, therefore, is ignored for the 70% property test.[24]
As previously discussed, 70% of the QOF subsidiary’s tangible property must be QOZBP, and in order to constitute QOZBP, the tangible property must (collectively, the QOZBP requirements): 1) be used in a trade or business; 2) be either purchased from an unrelated party after December 31, 2017 (purchased QOZBP), or leased under a “market-rate” lease entered into after December 31, 2017 (leased QOZBP); 3) be either substantially improved or meet the original use requirement (each as defined below); and 4) during substantially all of the holding period for such property, substantially all of the use of such property must be in a QOZ.[25]
3) Purchased QOZBP and leased QOZBP: QOZBP must be either purchased or leased. Purchased QOZBP may not be acquired from a related person, and for these purposes, a 20% related ownership test is applied.[26] Leased QOZBP, however, may be leased from a related party, but any such related-party leases are subject to additional requirements (related-party lease rules), including that the lessee may not make prepayments under the lease exceeding 12 months.[27]
• Example 8 (Related-Party Purchase) — The facts are the same as example 7, except that following the QOF’s $9 million contribution to the QOF subsidiary, the QOF subsidiary purchases land from the investor (Greenacre) within a QOZ with a building located on Greenacre (building) for $5 million.
Analysis: Investor is related to the QOF subsidiary because he or she owns 80% of the QOF’s equity interest, and the QOF owns 95% of the QOF subsidiary’s equity interest. Therefore, the QOF subsidiary purchased Greenacre and building from a related person (i.e., the investor), and as a result, Greenacre and the building will not constitute QOZBP and will count against the 70% property test.
• Example 9 (Leased QOZBP) — The facts are the same as example 7, except that the QOF subsidiary leases Greenacre and the building from the investor. Assuming that the related party lease rules are satisfied, Greenacre and the buildings constitutes valid QOZBP and counts toward the 70% property test.
4) Substantially Improved and the Original-Use Requirement: As discussed above, in order to constitute QOZBP, the property must also be either substantially improved or satisfy the original use requirement. Very generally, property is “substantially improved” if, during any 30-month period, the QOF subsidiary spends as much to improve the property as its basis in the property at the beginning of the 30-month period (i.e., the property’s basis must be “doubled”).[28]
The initial regulations and new regulations, however, provide additional flexibility for investments in real estate. First, for improved real estate, the amount allocated to land is ignored for purposes of determining if the property is substantially improved.[29] Second, the new regulations confirm that raw land is not required to be substantially improved, and go even further by providing that improved real property is also not required to be substantially improved if the building on such real property has been vacant for at least five years from the date acquired.[30]
Even if property is not substantially improved, the property may still constitute QOZBP if it meets the original use requirement. The “original use requirement” is satisfied if the QOF subsidiary is the first person to be able to depreciate or amortize such property in a QOZ.[31] However, the IRS has ruled that, given the permanence of land, land can never satisfy the original use requirement, so the substantially improved rules are generally the focus of QOZ real estate investments.[32]
• Example 10 (Substantial Improvement) — The facts are the same as example 7, except that the QOF subsidiary uses $5 million of the $9 million received from the investor to purchase Blackacre and building from an unrelated third-party, allocating $3 million to the building and $2 million to Blackacre; the QOF holds the remaining $4 million received in cash, which will be used to improve the building.
Analysis: The QOF may substantially improve the building by investing more than $3 million in improvements to the building during any 30-month period following the purchase.
5) Active Trade or Business: In order to qualify as a QOZB, at least 50% of the QOF subsidiary’s income must be from an active trade or business.[33] The new regulations confirm that ownership and operation (including leasing) of real property is an active trade or business, but merely entering into a triple-net lease is not.[34]
6) The 5% Cash Test and Working-Capital Exception: In addition to the 70% property test, the QOF subsidiary must meet the 5% cash test, which requires that less than 5% of the QOF subsidiary’s property be in “nonqualified financial property,” which, unlike the 70% property test, includes cash held in bank accounts.[35] Therefore, under this rule, a QOF subsidiary may not have more than 5% of its property in cash.
The initial regulations, however, contain a working capital safe-harbor (working capital exception), which excludes certain amounts of cash from the 5% cash test.[36] The working capital exception excludes cash for a period of up to 31 months, if 1) the amounts are designated in writing for the development of a trade or business in a QOZ, including the acquisition, construction, and/or substantial improvement of real estate; 2) the written schedule is consistent with ordinary business operations and provides for the deployment of the capital within the 31-month period; and 3) the capital is actually used in a manner that is substantially consistent with this written schedule. The new regulations provide additional flexibility and provide that exceeding the 31-month period due to waiting for government action will not violate the working capital exception.[37]
• Example 11 (Working Capital Exception) — Facts are the same as example 10.
Analysis: The QOF subsidiary purchased Blackacre and the building for $5 million, and as a result, the QOF subsidiary has $4 million in cash in its bank account after the acquisition in order to construct the desired improvements. If QOF subsidiary develops a written schedule meeting the working capital exception, then the $4 million held in cash is ignored for the 5% cash test. Assuming this cash is deployed consistent with the written schedule over the following 31 months, the substantial improvement requirement would also be satisfied; only $3 million was allocated to the building, so the substantial improvement requirement would be satisfied if the building was improved by more than $3 million. At this point, assuming the other QOZB requirements are satisfied, the QOF subsidiary would be a QOZB. Therefore, the subsidiary interest would be QOZP, and as the QOF’s sole, the QOF would have 100% of its assets in QOZP and, thus, satisfy the 90% asset test.
Conclusion
The QOZ program provides an opportunity to spur economic growth and investment in otherwise economically distressed areas, and at the same time, provide investors with significant tax benefits. The new regulations continue to encourage QOZ investments through QOF subsidiaries, which contain many structuring challenges for transactions. Therefore, advisors need to work closely with all parties to a QOZ transaction to ensure all of the requirements are satisfied.
[1] See generally 26 U.S.C. §1400Z-2 (2018).
[2] Investing in Qualified Opportunity Funds, 83 Fed. Reg. 54,279 (proposed Oct. 29, 2018).
[3] Investing in Qualified Opportunity Funds, 84 Fed. Reg. 18,652 (proposed May 1, 2019).
[4] 26 U.S.C. §1400Z-2(a)(1).
[5] Unless otherwise indicated, any section reference in this article is a reference to the applicable section of the Internal Revenue Code of 1986, as amended.
[6] 26 U.S.C. §1400Z-2(b)(2)(B)(iii), (iv).
[7] 26 U.S.C. §1400Z-2(c).
[8] Prop. Reg. §1.1400Z-2(a)-1(b)(3)(i); Prop. Reg. §1.1400Z-2(a)-1(b)(9).
[9] Prop. Reg. §1.1400Z-2(a)-1(b)(9)(ii).
[10] Prop. Reg. §1.1400Z-2(a)-1(a), (b)(2).
[11] 26 U.S.C. §1400Z-2(a)(1), (e)(2).
[12] 26 U.S.C. §1400Z-2(a)(1)(A).
[13] Prop. Reg. §1.1400Z-2(a)-1(c).
[14] 26 U.S.C. §1400Z-2(b)i.
[15] Prop. Reg. §1.1400Z-2(b)-1(c)(6)(ii); Prop. Reg. §1.1400Z-2(a)-1(b)(10)(ii).
[16] Prop. Reg. §1.1400Z-2(b)-1.
[17] 26 U.S.C. §1400Z-2(d).
[18] I.R.S. Form 8869, Part I, line 3.
[19] 26 U.S.C. §1400Z-2(d)(1).
[20] Note that the new regulations provide additional relief by allowing a QOF to apply the 90% asset test without taking into account any investments received in the preceding six months. Prop. Reg. §1.1400Z-2(d)-1(b)(4).
[21] 26 U.S.C. §1400Z-2(d)(3).
[22] Id.
[23] Prop. Reg. §1.1400Z-2(d)-1(d)(3).
[24] 34B Am. Jur. 2d, Federal Taxation ¶148,115; see also IT&S of Iowa, 97 T.C. 496 (1991).
[25] 26 U.S.C. §1400Z-2(d)(2)(A); Prop. Reg. §1.1400Z-2(d)-1(c)(4).
[26] Prop. Reg. §1.1400Z-2(d)-1(c)(4)(i)(A); 26 U.S.C. §1400Z-2(e)(2).
[27] Prop. Reg. §1.1400Z-2(d)-1(c)(4)(i)(B).
[28] 26 U.S.C. §1400Z-2(d)(2)(D)(ii).
[29] Prop. Reg. §1.1400Z-2(d)-1(d)(4)(ii).
[30] Prop. Reg. §1.1400Z-2(d)-1(c)(4)(i)(B)(6).
[31] Prop. Reg. §1.1400Z-2(d)-1(c)(4)(i)(B)(7).
[32] Rev. Rul. 2018-29, 2018-45 I.R.B. 765 (2018).
[33] 26 U.S.C. 1400Z-2(d)(3)(A).
[34] Prop. Reg. §1.1400Z-2(d)-1(d)(5)(ii)(B)(2).
[35] 26 U.S.C. §1400Z-2(d)(3)(A)(ii); 26 U.S.C. §1397C(b)(8).
[36] Prop. Reg. §1.1400Z-2(d)-1(c)(5)(iv)(B).
[37] Prop. Reg. §1.1400Z-2(d)-1(c)(5)(iv)(C).
JUSTIN WALLACE is a tax attorney at the law firm of Hill Ward Henderson in Tampa. His practice primarily involves federal and state tax planning for business transactions, including the tax consequences arising from formation, operation, ownership, and sale of C corporations, S corporations, partnerships, and limited liability companies. He also works closely with developers and investors in real estate transactions, including investments in qualified opportunity zones.
This column is submitted on behalf of the Real Property, Probate and Trust Law Section, Robert S. Freedman, chair, and Douglas G. Christy and Jeff Goethe, editors.
